S Corporation vs. C Corporations

The term "S-Corporation" doesn't mean "small corporation." This type of business structure is named for Subchapter S of the Internal Revenue Code. An S-Corporation offers shareholders protection against the business's liabilities.

S-Corps are a subset of a corporation. First, a corporation must be formed, then the S-Corp status may be elected. The Internal Revenue Service (IRS) has specific requirements to qualify to elect this status using Form 2553. The corporation must

• Be a domestic (U.S.) corporation
• Must have no foreign owners
• Have no more than 100 approved shareholders
• Can issue only one class of stock 

For tax purposes, an S-Corporation is considered a tax pass-through entity. The shareholders only pay taxes based on their allocated share of the income of the company. They report the passed-through income on their personal tax returns. Corporate losses, deductions, and credits also pass through to the owners. Also, even if the corporation did not pay dividends to the shareholders, they will still owe taxes based on their portion of the corporation's income.

Limited liability companies (LLCs), limited partnerships (LLP), sole proprietorships, and master limited partnerships (MLP) are all types of S-Corps.

A C-Corp is what you have if you do not elect S-Corp status with the IRS. Owners of C-Corporations and owners of S-Corporations have the same protection against lawsuits brought against the corporation. Because the activities of the corporation are separate, its liabilities cannot be legally transferred to its shareholders.

The corporation's shareholders cannot be sued on behalf of the corporation, nor are they personally responsible for debts it incurs. This separation is sometimes called a "corporate shield," but the shield can be pierced if an owner, board member, or executive acts outside the bounds of the law or the duties and responsibilities of their office.

Taxation draws the most definitive line in the sand between S- and C-Corps. Shareholders in a regular or C-Corp may receive dividends or shares of the corporation's revenue, and they may sell their shares for a profit or loss. However, these owners have a double tax dilemma.

The corporation pays taxes on its profits and the owners are additionally taxed on the dividends they receive. Owners of a corporation who work in the business—typically in executive positions—are considered employees. They must be paid a reasonable salary and are also taxed on this personal income. 

An S-Corporation does not pay dividends to its owners. The business files a tax return—Form 1120S—on which it shows its net profit or loss for the year. This amount is passed through to the individual shareholders and reported on their personal returns even if it is not actually received by the owner in the form of dividends. When the business passes through a loss, it becomes a deduction for the shareholder—up to the amount of their original investment.

The S-Corp issues each shareholder a Schedule K-1, showing the amount of profit or loss allotted to that individual. The shareholders must then report the K-1 income on their personal tax returns. This profit or loss is added to their other income and deductions.